Oct 15, 2011

Kahneman's "Thinking, Fast, and Slow"

In Mr. Kahneman's important new book, "Thinking, Fast and Slow," his first work for a popular audience, he outlines the implications of this new model of cognition. What are the most important mental errors that we all make? And can they be overcome?

Consider the overconfidence bias, which drives many of our mistakes in decision-making. The best demonstration of the bias comes from the world of investing. Although many fund managers charge high fees to oversee stock portfolios, they routinely fail a basic test of skill: persistent achievement. As Mr. Kahneman notes, the year-to-year correlation between the performance of the vast majority of funds is barely above zero, which suggests that most successful managers are banking on luck, not talent.

This shouldn't be too surprising. The stock market is a case study in randomness, a system so complex that it's impossible to predict. Nevertheless, professional investors routinely believe that they can see what others can't. The end result is that they make far too many trades, with costly consequences.

And it's not just investors who suffer from this mental flaw. The typical entrepreneur believes that he or she has a 60% chance of success, though less than 35% of small businesses survive more than five years. Meanwhile, CEOs who hold more company stock—taken here as a sign of self-confidence—also tend to make more irresponsible decisions, overpaying for acquisitions and engaging in misguided mergers.

Even consumers are hurt by this bias. A recent survey of American homeowners found that they expected, on average, to spend about $18,500 on remodelling their kitchens. The actual average cost? Nearly $39,000.

We like to see ourselves as a Promethean species, uniquely endowed with the gift of reason. But Mr. Kahneman's simple experiments reveal a very different mind, stuffed full of habits that, in most situations, lead us astray. Though overconfidence may encourage us to take necessary risks—Mr. Kahneman calls it the "engine of capitalism"—it's generally a dangerous (and expensive) illusion.

What's even more upsetting is that these habits are virtually impossible to fix. As Mr. Kahneman himself admits, "My intuitive thinking is just as prone to overconfidence, extreme predictions and the planning fallacy as it was before I made a study of these issues.""

Even when we know why we stumble, we still find a way to fall.

One of the problems in this article [and I should read the book for clarification] is the definition of "rationality" and "irrationality." There are different versions of rationality [and as a corollary, of irrationality as well], from weak to very strong. Strong rationality, in the sense of rational expectations (which comes from John Muth) indicates that people have in their minds the right model of reality - which we know is practically impossible. There are computational limitations in the brain, like Herbert Simon explained.

If people were more rational, meaning that they don't overestimate the probability of success, then those who start a new business will succeed. However, it might be possible that the business that succeed in this case are different from the businesses that survive when people overestimate their chances of survival. Did Steve Jobs overestimate his probability of success? May be failure to estimate the right probability is at the core of success in innovation [but again, I am sure Kahneman talks about this in his book].

An insurmountable task is the complex calculation of costs and benefits when people overestimate their chances of success.